Doomed-i-corns: Unicorns Seemingly Reach a Tipping Point

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This morning, the law firm Fenwick & West published new findings about all the U.S.-based unicorn financings that took place during the last nine months of 2015. It’s rife with interesting nuggets, but perhaps most fascinating is that in the fourth quarter of last year, half of the 12 rounds it tracked featured valuations in the $1 billion to $1.1 billion range — and with terms that were far more onerous than earlier in the year.

Fenwick & West politely suggests these companies may have been “willing to be more flexible” regarding “investor friendly terms” in order to attain their billion-dollar-plus valuations. We’d call it bone-headed.

The instinct is understandable, to a degree. For the last couple of years, the media has been almost singularly obsessed with companies valued at north of a billion dollars. Some management teams invariably concluded that to attract the attention of reporters and even potential recruits, they needed so-called unicorn status.

Slack is among them. CEO Stewart Butterfield told Fortune in January of last year that if he couldn’t get a billion-dollar valuation straightaway for his company, he wouldn’t raise capital at all, saying the valuation was a “psychological threshold” for “certain types of customers” who want the “comfort of knowing we’re highly valued and financially secure.” Butterfield said the valuation helped with hires, too. “There is a class of employees who are more risk-averse and work at some company like Google or Facebook and they have a mortgage and kids,” he told Fortune. “It helps a lot of those kinds of people as well.”

Well, it does until it doesn’t.

By last fall, plenty of employees were beginning to sense a serious downside to being part of a unicorn company. For one thing, outlets like this one were beginning to write more about the liquidation preferences that later-stage investors have come to demand, and the impact such terms have on earlier employees’ holdings.

More employees also began to learn the hard way that when a company’s valuation soars too quickly, the amount of money that the employee needs to buy his or her options escalates too fast for anyone who isn’t already well off to afford them. (Selling to secondary buyers is sometimes an option permitted by management, but even then, settling on a fair price isn’t easy.)

Perhaps most meaningfully, investors were starting to catch on to problems with their fast-growing portfolio companies, including Fidelity and Blackrock, which began massively marking down the value of some of their holdings (and attracting the attention of a confused SEC in the process).

Indeed, almost overnight, the term “unicorn” became such a liability that industry wags coined a newer term: unicorpses.

The note-taking app maker Evernote, once lauded for cleaning its employees’ homes every two weeks and offering them unlimited vacation, suddenly began to make headlines for other reasons, including switching its CEO, losing its COO, staging layoffs, killing off products and closing offices.

Of course, this week, high-flying Zenefits – a 3.5-year-old online health benefits manager that managed to garner a $4.5 billion valuation back in May — booted its co-founder and CEO, Parker Conrad, over the company’s “inadequate” internal processes, controls, and actions around compliance (in the words of its new CEO, David Sacks).

Even pop culture has piled on, with HBO’s “Silicon Valley” being just one show portraying the seeming lunacy and entitlement of today’s would-be tech billionaires.

In the midst of all this, we’re unsure why a CEO would angle for a billion-dollar valuation in the fourth quarter, particularly at terms that were so disadvantageous. Fenwick’s research shows that in 42 percent of the fourth-quarter rounds, investors received senior liquidation preferences, meaning preference over common stock and also other series of preferred stock. That was way up over the third and second quarters of last year, when only 15 percent of rounds included senior liquidation preferences. (In 2014, 19 percent of deals included these terms.)

Blocking rights – which give investors the right to block an IPO if it isn’t priced as high as the unicorn round price, or in some cases, even higher than the unicorn price – also became far more prevalent, with 33 percent of deals including them, versus 25 percent in the third quarter and 20 percent in the second quarter.

Investors basically ask for these terms, and get them, when entrepreneurs don’t have a whole lot of leverage in exchange for the money and valuation they want.

There does seem to be a silver lining in Fenwick’s new report, though. Its numbers suggest we’ve seen a tipping point in unicorn mania.

The reason: There were more unicorn financings in the last three quarters of last year than in the previous 12 months, but the rate of companies becoming newly minted unicorns dropped precipitously in the fourth quarter. (You can see the study here.)

The entire unicorn phenomenon is awfully young, but it’s the first time we’ve seen that kind of dip. (As you may recall, the numbers of unicorns until last quarter have only accelerated over time.)

Such is our interpretation, anyway. Asked if he agrees that we’ve just witnessed an inflection point, Barry Kramer, one of the Fenwick study’s three authors, tells us it’s entirely possible, but he thinks it’s probably too soon to know for certain, noting that “a lot of variables determine which path a company takes.”

Says Kramer, “For a number of years, the private-financing unicorn path has been very attractive. But if the terms in unicorn deals start becoming significantly worse, or valuations become significantly worse, or it becomes harder to raise financing, the other alternatives” — including going public, cutting burn rates, and selling to an acquirer — “start looking better.”

VCs aren’t ready to call a top, either. At the same time, some have observed a palpable shift in startup thinking of late.

“We counsel founders to focus on who is the right [investment] partner for their stage and needs, then to try to find mutual ground,” says Hunter Walk, a co-founder of the San Francisco-based venture firm Homebrew. “Of course, a competitive environment and strong company performance will help founders push the market to them,” Walk adds. “But founders – and employees – are being reminded by high-profile stumbles that valuations are a byproduct of great performance, not vice-versa.”

“I think if entrepreneurs think their company is worth [a billion-plus dollars], they still want that kind of valuation,” says Greg Gretsch, a co-founder of Jackson Square Ventures in San Francisco.

That said, adds, Gretsch, “People are listening a little more. We’ve always tended to be on the more conservative side in our guidance to companies. You try to keep people from doing stupid things. It’s not like we’ve changed who we are or the advice we provide. But now there’s not as much of a debate [about the value of that advice]. Now it’s ‘Maybe I should think about X before I do Y.’”